term sheets

My last 2 posts were about things to avoid, so I thought it might be helpful to follow up with something more positive. Having been part of or observed about 50 early stage deals, I have come to believe there is a clearly dominant set of deal terms. Here they are:

– Investors get either common stock or 1x non-participating preferred stock. Anything more than that (participating preferred, multiple liquidation preferences) divide incentives of investors and the entrepreneurs. Also, this sort of crud tends to get amplified in follow on rounds.

– Pro rata rights for investors. Not super pro rata rights (explaining why this new trendy term is a bad idea requires a separate blog post). This means basically that investors have the right to put more money in follow on rounds. This should include all investors – including small angels when they are investing alongside big VCs. There are two reasons this term is important 1) it seems fair that investors have the option to reinvest in good companies – they took a risk at the early stage after all 2) in certain situations it lets investors “protect” their investments from possible valuation manipulation (this has never happened to me but more experienced investors tell me horror stories about stuff that went on in the last downturn – 2001-2004).

– Founder vesting w/ acceleration on change of control. I talk about this in detail here. If your lawyer tries to talk you out of founder vesting (as some seem to be doing lately), I suggest you get a new lawyer.

– This stuff is all so standard that there is no reason you should pay more than $10K for the financing (including both sides). I personally use Gunderson and think they are great. Whoever you choose, I strongly recommend you go with a “standard” startup lawfirm (Gunderson, Wilson Sonsini, Fenwick etc). I tried going with a non-standard one once and the results were disastrous. Also, when you go with a standard firm and get their standard docs it can expedite later rounds as VCs are familiar with them.

– A board consisting of 1 investor, 1 management and 1 mutually agreed upon independent director. (Or 2 VCs, 2 mgmt and 1 indy). As an entrepreneur, the way I think of this is if both my investors and an independent director who I approved want to fire me, I must be doing a pretty crappy job and deserve it.

– Founder salaries – these should be “subsistence” level and no more. If the founders are wealthy, the number should be zero. If they aren’t, it should be whatever lets them not worry about money but not save any. This is very, very important. Peter Thiel said it best here. (I would actually go further and say this should be true of all employees at all non-profitable startups – but that is a longer topic).

– If small angels are investing alongside big VCs, they should get all the same economic rights as the VCs but no control rights. Economics rights means share price, any warrants if there are any (hopefully there aren’t), and pro-rata rights. Control rights means things like the right to block later financings, selling the company etc. I once had to track down a tiny investor in the mountains of Italy to get a signature. It’s a real pain and unnecessary.

– Option pool – normally 10-20%. This comes out of the pre-money so founders should be aware that the number is very important in terms of their dilution. Ideally the % should be based on a hiring plan and not just a deal point. (Side note to entrepreneurs – whenever you want to debate something with a VC, frame it in operational terms since it’s hard for them to argue with that).

– All the other stuff (registration rights, dividends etc) should be standard NVCA terms.

– Valuation & amount- My preference is to keep all terms as above and only negotiate over 2 things – valuation and amount raised. The amount raised should be enough to hit whatever milestones you think will get the company further financing, plus some fudge factor of, say, 50% because things always take longer and cost more than you think. The valuation is obviously a matter of market conditions, how competitive the deal is etc. One thing I would say is if you expect to raise more money (and you should expect to), make sure your post-money valuation is one that you will be able to “beat” in your next round. There is nothing more dilutive and morale crushing than a down round.